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In this video lesson on economics, you will come to understand how banks create money. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

About this Author

Founded in 1997, Thinkwell has succeeded in creating "next-generation" textbooks that help students learn and teachers teach. Capitalizing on the power of new technology, Thinkwell products prepare students more effectively for their coursework than any printed textbook can. Thinkwell has assembled a group of talented industry professionals who have shaped the company into the leading provider of technology-based textbooks. For more information about Thinkwell, please visit www.thinkwell.com or visit Thinkwell's Video Lesson Store at http://thinkwell.mindbites.com/.

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Although the Federal Reserve has a lot of control over the money supply, most of the money that is out there, is created by banks. The processes by which banks create money is nothing short of magic. To understand the way banks create money, remember that bank reserves put a limit on the number new checking accounts that banks can create. Anytime a bank makes a loan, the bank makes a loan by creating a checking account. That is, the loan is an asset of the bank, money that is owed the bank, on which the bank is earning interest. The checking account is a liability. The Federal Reserve watches checking accounts because they are part of the money supply, part of what people use to go shopping. So there is a restriction on the creation of new checking accounts, and that restriction is that for every new dollar that banks create in checking accounts they have to have reserves equal to 10 cents. Reserves have to be held in the form either of cash or reserve deposits, that is, the bank's own deposits at the Fed. Once you understand that there is a reserve requirement, the process by which banks create money becomes very, very interesting, and ends up with the concept that we call the money multiplier. The money multiplier explains how a little bit of action from the Fed can create a lot of new money the banking system.
Let's see how it works. Suppose you, a securities dealer, decides to do a transaction with the Fed. You sell a security to the Fed and the Fed gives you a check. You take that check to your bank. Let's suppose your bank is called "Bank A." Let us look at how the deposit of that check shows up on the bank's balance sheet. Here on this "T" account I'll put bank assets on the left and bank liabilities on the right. Suppose the check you deposit is for $1000.00. The first the first thing that happens is the bank has a new liability. That is, the bank owes you a $1000.00, which is the amount of money that you put into your checking account. We are going to call you person number one. When the bank takes the check you deposited and presents it to the Fed, the Fed can do one of two things. Either the Fed can give the bank cash or the Fed can give the bank credit in that banks reserve account at the Fed. Either ways Bank A winds up with an increase in its reserves of $1000.00. So the $1000.00 checking deposit winds up as an increase in bank reserves because it's coming from the Fed. The bank takes the check to the Fed and gets reserves in exchange.
The bank has some thinking to do. It's got $1000.00 in reserves but only a $1000.00 new dollars in checking. Since the bank only needs to hold a fraction of this as a legal reserve requirement, it can lend out the rest. Let's see how the bank does the calculation. The bank says to itself, "We have $1000.00 in new checking times a required reserve ratio of 10 percent means that we have got to hold $100.00 as required reserve. That means that if we subtract that $100.00 from our $1000.00 of reserves, $900.00 of that reserve is lendable." The bank is going to lend it out as soon as it can because it is only the loan that earns interest. The reserves earn no interest. So the bank very quickly makes a loan and that is going to increase its loan portfolio by $900.00. So $900.00 in loan is created and the bank creates the loan by giving somebody a new checking account.
Let's say Jane comes in and she wants to expand her bakery. She needs to buy a new oven that costs $900.00, so she borrows the money from the bank. The bank gives her a checking account, and she writes a check to the appliance company that brings the new oven to her store. What happens when that occurs? Jane withdraws the money from her checking account. Her checking balance of $900.00 is drawn down to zero. Meanwhile, the bank that the appliance company uses brings Jane's check back to Bank A and wants to clear it somehow. It can either be cleared by giving the new bank cash or by giving the new bank $900.00 worth of Bank A's reserves at the Fed. Either way will do. Whatever happens, Bank A winds up with $900.00 less in its reserve account than it had before. Let us look at what has happened on net here. After all the dust has settled and Bank A has done its business, the net result is that a $1000.00 in reserves came in; $900.00 in reserves went out. The net increase in reserves at Bank A is $100.00. Meanwhile, Bank A has had a net increase in checking deposits of $1000.00. It created an account for Jane, but Jane withdrew it immediately, leaving your account as the net change in checking, a $1000.00. If we take the ratio of the change in reserves to the change in checking, that ratio is equal to 10 percent. We say that Bank A is now "loaned up" because they cannot legally make anymore loans without violating their reserve requirement. Notice the interesting step is where Bank A created money. That is Bank A created money that did not exist previously just by the stroke of a pen. By making a loan to Jane and giving Jane a checking account, Bank A created new money. This money is added to the money supply.
I am gong to set this money aside because in a minute I am going to ask how much money is created in total by the time we reach the end of the story. So we will put the money created by Bank A over here on the side and bring it back in a minute.
Meanwhile, let us follow this $900.00 in reserves that left Bank A and wound up at Bank B, the bank of the appliance dealer from which Jane bought her new stove. Let us consider how that works. The appliance dealer brings in a check from Jane for $900.00, and the appliance dealer we are going to call person number three. Bank B took that check to Bank A as we saw before and acquired $900.00 in new reserves.
Now Bank B has a calculation to do. Bank B asks it self, "How much of this money do we have to hold and how much of it can we lend? Our new checking account is $900.00. So $900.00 times 10 percent is 90. It takes $90.00 of reserves to back this checking account." Subtract 90 from $900.00 and that means that Bank B can create a loan equal to $810.00. Bank B is eager to do that as soon as it can so it does not lose a moment's worth of interest.
Let's suppose Jack comes in and he wants to take a vacation. He is going to borrow money from Bank B. So Bank B creates a checking account for Jack. He is person number four. What happens next is Jack takes his checkbook to his travel agent, writes a check for $810.00. The travel agent presents the money to his bank. His bank shows up at Bank B and wants reserves to clear the check. So, $810.00 worth of reserves flow out of Bank B to make Jack's check good. What is the net result of all this action at Bank B? The net result is $900.00 worth of reserves came in. $810.00 flowed out to clear Jack's check and the net change in reserves is $90.00. The net change in checking is that $900.00 that the appliance dealer brought in. The ratio of the change in reserves to the change in checking is 10 percent. Again, the most interesting thing on this T account is right here, the step from Bank B created some new money. Money that did not previously exist but they created by making a checking account for Jack. So let's put this money over to the side.
By now you get the point. I could go on and on, Bank C would have the same set up and the same numbers only they would be 90 percent of these numbers. Bank B would have numbers that are 90 percent of those. By now we're ready to ask the question, "How much does the money supply change in response to that security that you sold to the Fed?" You sold $1000 security to the Fed. You got $1000 check you deposited in your bank and set in motion a chain reaction. What is the total change in the money supply? The total change in the money supply is going to be equal to, first of all, the money that came from the Fed. The money that came from the Fed was $1000. Then there was the money that was created by Bank A when Bank A made that loan to Jane. That was $900.
Then there was the money that was created by Bank B when they made a loan to Jack that was $810. Bank C creates a loan of $729. It just keeps going. Each number is 90 percent of the number before. Why? Because banks are able to lend out 90 percent of the new reserves they get. That means the total is going to be 1000 + 900 + 810 + 729 and so forth. If you add all this up, Bank D, E, F and so on for infinity you get 10,000, ten times the original amount of money. How do we know that? We know that, first of all, because you could do it by brute force, just adding up the numbers forever, but the easier way is we have got a geometric sequence here. The geometric sequence is the net change in the money supply is equal to 1000 times 1, which came from the Fed, plus 90 percent, which was created by Bank A, plus 90 percent of 90 percent or 81 percent, which was created by Bank B and so forth. Anytime you have a geometric sequence like this, it has an easy, simple expression. It is minus whatever this term is. In this particular case, it is minus the fraction that banks are allowed to lend. The fraction that banks are allowed to lend is 1 minus the required reserve ratio. In our case, the required reserve ratio is 10 percent, so the fraction that banks are allowed to lend is 90 percent. That gives you insight into the money multiplier. The money multiplier is simply minus the required reserve ratio or the change in the money supply that results from the change in reserves, and that comes from anything the Fed buys, is equal to 1 over the required reserve ratio. If the required reserve ratio is 10 percent, the money multiplier is 10. If the required reserve ratio is 50 percent, then it's , the money multiplier is two. The bigger the required reserve ratio, the more money each bank has to keep in its own vault and the less it can lend, the fewer new checking accounts they can create. The smaller the required reserve ratio, the more banks can lend and the more easily they can create checking accounts turning a small amount of new reserves into a big increase in the money supply.
If we take all those little pieces of money that we started with and add them up, here is the amount that was created for Jane. Here is the amount that was created for Jack. Here is the amount that was created in the next stage, and in the next stage, and the next stage, until the pieces are too small to add up. The end-result is a total change in the money supply. The total change in the money supply is going to be the original change from the Fed multiplied by the money multiplier, which is one over the required reserve ratio.
Money: Banking, Spending, Saving, and Investing
The Creation of Money
How Banks Create Money Page [3 of 3]

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